Avoiding allegations of improper tax advice

Casual advice creates big exposure for malpractice claims.

On the golf course, an older client mentions that he has pledged an
endowment to his alma mater. Knowing the client does not need his IRA
funds for retirement purposes, the CPA mentions that certain taxpayers
can make distributions directly from their IRAs without the
distribution being included in taxable income.

If the client subsequently makes the contribution but does not
qualify for the income exclusion because he is not age 70½ at the time
of the distribution, the client may assert a claim against the CPA for
the additional taxes incurred. In the event of a claim, the client may
allege that the CPA provided him with improper tax advice upon which
he relied in deciding to contribute to his college through his IRA.
CPAs often give off-the-cuff advice, especially in a tax practice.
Claim experience of the AICPA Professional Liability Insurance Program
shows that casual advice, especially when it is not documented in the
tax preparer’s file, increases the possibility that a malpractice
allegation related to such advice will be successful.

This article summarizes the risks associated with providing casual
advice to clients and provides suggestions to mitigate the risk of
experiencing malpractice claims based on allegations of improper tax advice.

EXISTING CLIENTS

Casual advice is rendered regularly, especially in a tax practice.
Consider the following hypothetical:

A client mentions that he is considering selling a piece of real
estate and that, if he did, a large taxable gain would result. The CPA
indicates that if a like-kind exchange were completed, the gain could
be deferred. The CPA then walks the client through the requirements of
a Sec. 1031 exchange.

The following year, when compiling information to prepare the
client’s tax return, the client mentions to the CPA that the like-kind
exchange was completed and thanks her for the advice. Unfortunately,
while preparing the tax return, the CPA identifies that the exchange
was completed more than 180 days after the sale of the exchanged
property. As a result, the transaction does not qualify for deferral,
and the client is required to pay tax that was not anticipated.

Professional liability claims have been made arising from situations
such as this, alleging that the client relied on the CPA’s advice in
making the decision and that the deferred tax would not be owed but
for that reliance.

IS THERE A CPA IN THE HOUSE?

At dinner, a friend mentions that his company is growing and the
stock options he has accrued will be exercised for a large taxable
gain when the company goes public, probably in two years. The CPA
notes that if the options are exercised now instead of immediately
before being sold, the gain realized when the stock is sold would be
considered a long-term capital gain. The friend isn’t a client. Is a
CPA-client relationship created?

Claims have been made alleging that innocuous conversations such as
the above scenario created a CPA-client relationship and that the
“client” relied on this advice when deciding to exercise the options
early. If the value of the stock later declines, a claim may be made
alleging that the friend would not have exercised the options early if
the CPA had not advised him to do so in order to qualify for a
preferential tax rate.

When discussing tax matters casually, ensure that anyone who is not
a client understands that you are not providing tax advice, that you
are speaking broadly and not to his or her specific situation, and
that the tax consequences will vary greatly with each taxpayer’s facts
and circumstances.

TIPS FOR MANAGING THE RISK

With
existing clients, the risk of casual advice giving rise to a
malpractice claim is greater because the client relies on the CPA’s
advice. If a client discusses a subject outside your area of
expertise, either obtain the expertise, perform the required research
and confer with a professional who has this experience, or refer the
client to such a professional. Do not ignore the client’s concern.

Document all discussions in written correspondence to the client and
place a copy in the client’s file. Be especially careful to document
conversations in nonbusiness settings such as on the golf course or
during dinner. Advice written following the conversation should be
complete and may reference requirements not discussed.

If a
client requests a second opinion from you after conferring with other
professionals, consider declining to respond. Often, the CPA is
unaware of all of the facts, which may result in improper advice.
Clients, prospects, friends, or family members may sometimes engage in
“opinion shopping.” CPAs should be wary when it becomes clear that a
second opinion is being sought regarding a tax matter.

When
meeting with prospective clients, inform the prospect that a minimum
amount of information is initially required to determine if you are an
appropriate professional to serve the client’s needs. Any tax planning
strategies identified in a proposal should include disclosures
identifying the need to perform additional research based upon other
facts gathered when the prospect becomes a client.

With
prospective clients, clarify that a CPA-client relationship does not
exist, including the criteria for beginning such a relationship. If a
new client is not accepted by the firm, notify the client in writing
that a relationship does not exist, such as in a nonengagement or
declination letter. If the prospect has a looming deadline of which
you are aware, the client should be informed, in writing, that a
relationship does not exist. The written communication should advise
that a deadline is imminent and that the services of another
professional should be obtained.

In
discussions with friends and family who are not clients, refrain from
providing tax advice. There may be facts of which you are unaware that
could render the advice incorrect.

When
a client relationship ends, a termination letter should be issued
providing the client with notice that you no longer represent the
client. This applies to one-time-only engagements as well as
engagements in which the client terminates the CPA.

Claim experience has demonstrated that casual advice frequently
results in allegations of improper tax advice. However, with knowledge
of all of the facts, including research of applicable laws summarized
in written advice to the client, CPA firms can minimize the risk of a
professional liability claim.

Deborah K. Rood (deborah.rood@cna.com) is a risk control consulting director at CNA. Continental
Casualty Co., one of the CNA insurance companies, is the underwriter
of the AICPA Professional Liability Insurance Program. Aon Insurance
Services, the National Program Administrator for the AICPA
Professional Liability Program, is available at 800-221-3023 or
visit cpai.com.

This article provides information, rather than advice or opinion.
It is accurate to the best of the author’s knowledge as of the
article date. This article should not be viewed as a substitute for
recommendations of a retained professional. Such consultation is
recommended in applying this material in any particular factual situations.

Examples are for illustrative purposes only and not intended to
establish any standards of care, serve as legal advice, or
acknowledge any given factual situation is covered under any CNA
insurance policy. The relevant insurance policy provides actual
terms, coverages, amounts, conditions, and exclusions for an insured.

When professionals prepare written material for readers inside their organization or outside, they should make sure that no errors distract from the message they need to convey. Take this short quiz for practice in subject-verb agreement.